Lehman and the Shorts: Why Regulators Should Have Listened

By Matt Phillips

Traders who sell stock short became political footballs during the financial panic that peaked with the implosion of Lehman Brothers. They were persistently pointed to as the source of the problems for financial firms. And in one of the most traumatic moments of the financial crisis, the SEC temporarily banned short-selling of 799 financial stocks.

Defenders of short sellers say that investors betting against stock send important price signals to the marketplace.

Now, the recent report on the demise of Lehman by a U.S. bankruptcy court examiner contains some interesting detail on short sellers, most famously David Einhorn.

One of the Lehman’s biggest critics, the manager of hedge fund Greenlight Capital, famously delivered a critical speech on Lehman to a group of high-profile investors just as worries about Lehman were hitting a fever pitch.

The report provides a good quick description of Einhorn’s speech:

Before that presentation, Einhorn had corresponded with [Lehman CFO Erin Callan] in mid‐May 2008, as part of what he described as fact‐checking in advance of his presentation at the Ira Sohn Conference. Einhorn focused on four major issues in his correspondence with Callan and in his May 21, 2008 speech:
(1) Lehman’s disclosures regarding CDO exposure and related write‐downs;
(2) the difference between the amount of Level III assets disclosed in the Form 10‐Q filed in February 2008 and during Lehman’s first quarter 2008 earnings call;
(3) Lehman’s disclosure and valuation of its stake in KSK Energy;
(4) Lehman’s write downs of its CMBS assets.

On the day of Einhorn’s speech, Lehman’s stock closed down $2.44, with its highest volume of the entire month of May 2008. Einhorn’s criticism of Lehman and Callan is commonly cited as the reason for Callan’s replacement less than three weeks later.

Following the near collapse of Bear Stearns, Einhorn published a book, Fooling Some of the People All of the Time, which focused on [his years-long battle with Allied Capital Corp., a small, Washington-based lender that Einhorn accused of accounting and other misdeeds.]

Thomas C. Baxter, Jr., General Counsel to the FRBNY, said that reading Einhorn’s book made him think that the FRBNY should pay more attention to short sellers’ concerns. However, Baxter did not reach that conclusion for the reason that Lehman would have wanted, namely to persuade the Government to regulate short sellers, but rather because it appeared to Baxter that Einhorn may have been shorting Lehman for good cause. Baxter was unable to say, however, whether anyone at the Federal Reserve followed up on Einhorn’s criticism of Lehman in his speech.

So clearly, in the most basic sense Baxter saw short sellers as a good source of information.

Comments (4 of 4)

The problem with un-regulated short selling are the uninteded consequences of "killing the patient sooner". A bad company's shares will decline in any case, it would just take longer and create a better opportunity for a company to try and repair itself. This is silly, it's like giving gasoline to an arsonist.

Stupid actually, and completely unnecessary. You already have put options that give speculators the same ability to capitalize on failure.

1:12 pm March 12, 2010

Steve wrote :

How do you feel about a open market regarding price setting to short a stock?

In the current structure price setting occurs via the Goldmans of the world, not the market, additionally the Goldmans can create out of thin air additional shares... hence naked shorting.

Since you are a "honest" broker, even though you work for a right wing organization, why not wrap a "right to short" into every share of stock & have that right trade in the market. Every time a stock is exchanged so is the "right to short". In the current structure, as the price of a share drops so does the cost to short, never will the cost to short increase with a decreasing share price, but in FACT at some point you should (could) have the cost to short increase with a falling share price due to supply & demand.

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